Talk of Europe or Asia marching along "decoupled" from the US economy is now gone. No sooner had America's fourth-largest investment bank filed for bankruptcy on Monday than hundreds of suddenly jobless Lehman Brothers staff spilled onto the streets of London.
It was a tangible sign that global markets and economies are still intimately connected. Banks, insurance companies, pension funds, and mortgage companies from Tokyo to the City are closely tracking the handling of the US financial crisis. While exposure to the root of the problem – toxic securities derived from US subprime home loans – may be lower, financial systems elsewhere are feeling the same squeeze.
"This is a global crisis, not a local crisis," says Jeremy
Christian de Boissieu, deputy president of the Council of Economic Analysis, in Paris, says, "I've never believed in the theory of a 'decoupling' between Europe and the rest of the world. Europe has already been affected by this international financial crisis, along with an energy and food crisis."
That much was clear from financial markets on Tuesday. At one point, the London market fell to its lowest point for three years, the FTSE 100 index dipping below the 5000-point mark, which it first attained in 1997.
"There's a smell of cordite in the City this morning – you can still smell the gunpowder," says Justin Urquhart Stewart of Seven Investment Management and a prominent commentator on London's financial centre, known as the City. "There is a level of fear about how many other jobs will go. There will be more casualties."
European officials insisted on Tuesday that their institutions are to some extent insulated from the toxic fallout from their US counterparts. Subprime lending is less widespread in Europe. Banks tend to be underpinned by retail businesses instead of operating like the big broker-dealer houses familiar on Wall Street. "Happily," said French Finance Minister Christine Lagarde, "the French banks are affected only to a limited extent."
But the stock markets told a different story. French bank Natixis was down 17 percent at one stage Tuesday, but it wasn't the worst affected. Swiss giant UBS fell 21 percent before rebounding, and Britain's HBOS shares tumbled 22 percent, as traders fretted about whose balance sheet might be the next to fall apart under the strain.
"The focus is not just the banks but big insurers who are facing a double whammy – they're shareholders in banks and major participants in the credit derivatives markets," says Julian Jessop, chief economist at Capital Economics, a London consulting firm. "It doesn't really make a difference where they are based – these are global markets."
Attention is now focused on American International Group (AIG), the world's largest insurance company with more than 100,000 employees. On Tuesday, it was trying to raise as much as $75 billion in capital from the US Federal Reserve Bank or a consortium of banks.
The problem remains that no one really knows who is contaminated. One commentator likened it to trying to overcome a computer virus that has been e-mailed all around the global financial system. "My fear is that nobody knows what anybody's exposure is, which is why banks remain fearful about dealing with each other," says Mr. Batstone-Carr.
That essentially is why lending markets have dried up, generating a liquidity crisis that is threatening banks with perfectly good balance sheets: if they can't borrow, they can't lend and the primary purpose of banking is undermined.
In Britain, the home mortgage market has almost dried up and personal loans are difficult to get for anyone without impeccable credit ratings and large deposits. The housing market, long the driver of a decade of uninterrupted growth, has seized up with no money to lubricate it.
Central banks have tried to flush cash through the system. On Tuesday, the Federal Reserve, Bank of England, European Central Bank, and Bank of Japan pumped more than $200 billion into money markets. But everyone needs cash. Late Tuesday, the talk turned to the need for further interest rate cuts.
This market-based frenzy might seem rather theoretical for most people were it not for the wider implications for a global economy edging closer to recession. That impact could easily be seen in London on Monday as 2,500 Lehman Brothers staff packed up their possessions and started pondering their chances of finding a new job.
And the Lehman experience sends another clear message: central bankers are not necessarily prepared to bail out poor performing firms. Le Monde analyst Gaetan de Capele praised the move by US Treasury Secretary Henry Paulson: "The message for the future sent by Washington [by not] privatizing the profits and nationalizing the losses" is a good first step.
In short, expect more bankruptcies, more job losses, and a steady diminution in spending – the hallmarks of economic downturn.
"We expected job losses in any case because this is not a normal slowdown. But now there's far greater fear," says Mr. Urquhart Stewart, noting that London's financial sector is an important component of a British economy that is already forecast to tip into recession this year.
"In a best-case scenario," says Mr. Jessop, "the fallout could be limited to a couple of thousand bankers being unemployed for a few months; but when the underlying economy is weakened, you're getting a further blow to consumer and business confidence."
Market volatility is likely to discourage investment and dampen demand for goods, analysts say. But they also note that economies have continued to grow, albeit slowly, over the past year despite the exigencies of the credit crunch.
• Staff writer Robert Marquand contributed from Paris.